The Smart Contract Revolution

[Vrinda Vinayak is a 4th year B.A., LL.B (Hons.) student at the National Law University, Delhi]

Background

The concept of smart contracts was first envisaged by Nick Szabo in 1994. Such contracts consist of three essential elements. They are – (i) negotiated, coded and executed over the blockchain, in simple ‘yes-no’ or ‘if-then’ terms, (ii) authenticated by anonymous third-party ‘miners’ (who volunteer for this purpose and are rewarded in cryptocurrency based on the size of the transaction verified), and (iii) consideration for which is the cryptocurrency ‘Ethereum’. Distinctively, smart contracts eliminate the need for banks and other known third-parties to execute the consideration for the contract. As soon as the ‘if’ condition occurs and is verified (either by the party affixing a digital signature, or by other means), the ‘then’ condition is automatically satisfied on the blockchain. Further, a permanent, time-stamped and irreversible record of the transaction is created on the blockchain, which is accessible to each participant. However, the identity of the parties involved can potentially remain confidential, since each party is identified only through a code.

Legality of Smart Contracts in India

Gauging the validity of offer and acceptance, and legality of object under the Indian Contract Act 1872 for smart contracts would be no different than gauging these elements for traditional contracts. In fact, offer and acceptance for each term of the contract may arguably be easier to gauge for smart contracts, since a record of each party’s stance would be available on the blockchain. The main point of concern is whether Ethereum would constitute valid consideration for the contract. Cryptocurrency has not been defined under the Foreign Exchange Management Act, 1999, the Reserve Bank of India Act 1934 or Coinage Act 2011, and is hence believed not to be currency. While some countries like Japan and Australia have explicitly recognised it as legal tender and others like Bolivia and Nepal have declared it illegal, it stands unregulated in India. The Reserve Bank of India (RBI) has issued press releases clarifying that users of cryptocurrency must be cautious of its risks, and transact ‘at their own risk’. However, cryptocurrency could potentially be treated as non-monetary consideration that both parties ascribe value to. The transaction could be classified as a barter.

Advantages over Traditional ‘Paper’ Contracts

While execution and settlement of traditional contracts typically takes time, such execution happens instantaneously in the case of smart contracts upon authentication. Most importantly, as mentioned hereinabove, this system does away with the need to engage banks to execute the consideration for the contract, thereby significantly reducing transaction costs. In case of simpler contracts negotiable over the blockchain, the cost of hiring lawyers to facilitate formation is eliminated as well. Further, once recorded on the blockchain, details of negotiation and execution are difficult to tamper with, making the system more secure than traditional contracts and providing each participant with a reliable record of the transaction.

Challenges Associated with Smart Contracts

One of the most important concerns arising from the smart contract system is that it may promote criminal activity, since regulatory and law-enforcement authorities do not have access to details of the transaction, and the parties to it remain anonymous. Both these issues are easily resolved. Authorities could be made participants to the blockchain, thereby allowing them to oversee the transaction. It is also possible to use technology to track the identity of parties to an illegal transaction and bring them to book. However, if the identity of parties is traceable, a hitherto unaddressed concern is how confidentiality of smart contracts would be maintained, when it is authenticated by unknown miners who cannot be held accountable for their actions. Thirdly, not all transactions are negotiable simply in ‘yes-no’ or ‘if-then’ terms. Even individual clauses such as those regarding good faith and applicable law require detailed negotiations and the usefulness of the blockchain in this regard is questionable. However, smart contracts could still be useful as a complementary mechanism for execution of consideration in these complex transactions. Fourthly, it is believed that smart contracts hinder identification of the law applicable to the contract, if left unspecified. However, this issue can be overcome by tracing the location of the nodes through which each party negotiated the contract, or studying contract terms to determine the jurisdiction of closest connection. The technology for Decentralised Arbitration and Mediation Networks is also being developed to counter this issue. Lastly, smart contracts present evidentiary issues. The Indian Evidence Act 1872 (section 85B) only presumes the authenticity of electronic records digitally signed in accordance with the Information Technology Act 2000, creating issues regarding agreements digitally signed using the blockchain.

Commercial Uses of the Blockchain and Smart Contracts

Blockchain technology is fast gaining commercial acceptance in India. The State Bank of India recently launched ‘BankChain’, an initiative consisting of 27 banks sharing KYC data on the blockchain, to avoid duplication of effort and save costs. The RBI too proposes to utilise the blockchain to make banking activities smoother and more efficient. It is also being used in the pharma sector for maintenance of medical records, and the real estate sector to track devolution of title. It is only a matter of time before the full potential of the blockchain is realised, and smart contracts become mainstream as well.

In the securities market, smart contracts would function similarly to algorithmic trading, but in addition to placing a purchase order when certain preconditions are met, the program would also be capable of releasing payment automatically. Coupon payments could be released using smart contracts, and coordination for syndicated loans is likely to become easier with this technology. Smart contracts could also be used for other purposes like distribution of royalty, and supply chain management. Another potential use could be payment gateways for e-commerce websites, where payment would be released upon receipt of goods by the customer. Smart contracts can find use almost anywhere – the electricity meter in one’s house could be connected to the smart code, such that payment at the end of a cycle be calculated and made automatically on the blockchain. Similarly, a seismograph could be attached to the code so that an insurance pay-out could be made automatically when an earthquake of a certain magnitude hits a specified area.

Impact on Law Firms

The legal sector must evolve to cater to changing client-needs. While lawyers would undoubtedly be involved in the process of negotiation of complex contracts which the blockchain cannot yet accommodate, they must update their skillset once smart contracts are adopted. A basic understanding of the blockchain and coding on it would allow lawyers to ensure that the coded contract is a true reflect of party-intent. Collaboration with software firms would also be essential. There may also arise a need to rethink the hourly-billing model and charge per-transaction, or to charge a fee for hosting and coding contracts. Law firms can also capitalise on the thrust towards smart contracts by implementing it themselves. Smart contracts can be concluded with clients, simplifying the payment process. Partnership pay-outs could also be coded and executed using such contracts.

On a related note, if cryptocurrency were to be recognised as legal tender, law firms would need to further evolve. Lenders would enlist law firms to conduct due-diligence on cryptocurrency-based start-ups seeking loans. If the concern that users of cryptocurrency can transact anonymously persists, the firm will be expected to analyse the efficacy of the business’s transaction-tracking and client-identification mechanisms to prevent illegal activities. Clients will seek advice on the anti-corruption and financial regulation front, and might require assistance countering criminal allegations of non-transparency in cryptocurrency-driven dealings. If cryptocurrency is not legal globally, advising clients on consideration for cross-border deals could be another challenge.

Conclusion

While smart contracts may not be self-sufficient systems as of now, they are certainly ushering in a technological revolution that must be understood and adequately prepared for.

The opinions expressed herein are those of the contributors (which shall, for these purposes, include guests) in their personal capacity and do not, in any way or manner, reflect the views of the organizations that the contributors are presently associated with, or that have previously employed or retained the contributors. Postings on this blog are for informational purposes only. Nothing herein shall be deemed or construed to constitute legal or investment advice. Discussions on, or arising out of this, blog between contributors and other persons shall not create any attorney-client relationship.

Many of the links on this blog will take you to sites operated by third parties. The contributors of this blog have not reviewed all of the information on these sites or the accuracy or reliability of any information, data, opinions, advice, or statements on these sites. The contributors do not endorse these sites, or opinions they may offer. These third-party links are offered solely for the purpose of discussion and thinking on Indian corporate law and other related topics. It is also possible that some of the pages linked may become inactive after the lapse of a period of time.